Credit analysis of patent and trademark royalty securitisation: a rating agency
Intellectual property (IP) securitisation has taken a variety of forms since its creation in the mid-1990s. These have included music royalty, future film and trademark and patent licensing receivables transactions. In analysing the credit quality of those securities, Moody’s adapted its general asset-backed securities analysis to the many unique characteristics of the different IP businesses. This report explains those special characteristics and how they affect the credit analysis of the transactions.
IP-backed transactions are one form of future cash flow transactions. As with any future cash flow transaction, Moody’s analysis draws on expertise not only with the structuring and the particular assets being securitised, but also with the overall industry of which they are part. However, one characteristic that differentiates IP transactions from other types of future cash flow transactions (such as the securitisation of future cash flows generated by an oil pipeline) is that they are highly dependent on popular tastes or technological change, adding a layer of complexity and risk to the analysis.
The transactions done to date, totaling approximately $10 billion, represent only a thin slice of the potential IP securitisation market. They also represent a tiny percentage of the total securitisation market, which has completed over $1.2 trillion over the same period (See Figure 1). And since the use of IP continues to grow as a portion the economy as a whole, the intellectual property arena represents a vast potential market for securitisation.
The extent to which other intellectual property assets can be successfully securitised will depend in part on the degree to which a broad spectrum of investors become educated about their unique attributes. Moody’s does not expect that education will develop overnight, because there is little standardisation among these assets; consequently, issuance volume in this sub-sector of the securitisation market is unlikely to rival the $50 billion annual issuance of traditional asset-backed collateral types in the near to medium term. However, we expect issuance volume to increase steadily during the next two years, as at least some issuers are likely to find this type of financing to be more attractive than current forms.
Two sectors of the IP market that have been considered good candidates for securitisation are patent and trademark licensing royalties. Though both of these asset classes generate billions of dollars in annual revenue, issuance in these areas has been limited to date. This article will present the risks Moody’s considers when rating patent and trademark royalty securitisations, and possible solutions for covering these risks.
Patent licensing royalties
Patent licensing royalties is an IP asset class that a number of market participants are attempting to securitise. Through securitisation, companies holding patents can accelerate the realisation of the revenues generated by the licensing of a patented product or process, enabling them to more quickly recoup the often significant research and development costs incurred in creating the asset.
Though only two patent securitisations have been completed to date, a $100 million+ deal backed by the revenues generated by a university’s patent for an HIV/AIDS medication and a $200+ million facility backed by a portfolio of over ten pharmaceutical patents owned by Royalty Pharma, this market has huge potential. The licensing of patented technology is a $100 billion annual business involving thousands of companies. Whether this market develops will depend on the financing needs of the holders of these patents as well as their willingness to develop transaction structures that protect against the risks of these assets. Though it is difficult to gauge the current needs of these companies, the following sections highlight the risks that will need to be addressed to complete highly-rated patent revenue securitisations. These risks include:
• Technology marketing and acceptance
• Technological obsolescence
• Licensee payment risk
• Servicing risk
• Legal risks
Technology marketing and acceptance
New products using patented technology experience a period following their introduction that determines their market demand and the ability of their owner to meet that demand. Predicting the success or failure of a new product can be difficult and is speculative by its nature. This risk can be reduced by having licensing agreements lined up in anticipation of the granting of the patent, but even this does not guarantee the level of future sales or the abilities of the licensee and licensor to fulfill their obligations under the agreement.
As a result, it is difficult to accurately predict future revenues generated by the patent if there is no history of past revenues or performance. Patents in this stage of their lives will rarely be good candidates for highly rated securitisations. For a transaction to be completed at this early point in the product life cycle, a performance guaranty from a highly rated third party will probably be necessary.
A better candidate for securitisation is a patent that has moved past this stage and has demonstrated multiple years of collected revenues from one or more licensees. The chances of success for the transaction would be further enhanced if the agreements with the licensees extend into the future and if there is demonstrable evidence that there are additional uses for the technology.
Even if the technology has gained market acceptance and has demonstrated performance in the past, there is a risk that a superior technology will be developed during the life of the securitisation that makes the benefits of the patent obsolete. This risk is most acute in high technology industries, such as semiconductors and pharmaceuticals, where the pace of innovation is rapid. If this occurred, royalties generated by the patent, which are generally paid as a percentage of sales, could decline rapidly from the levels of earlier years. This risk could render historical revenues irrelevant.
To analyse this risk, Moody’s evaluates the factors that might limit the asset’s exposure to obsolescence during the life of the transaction:
(1) Short term of the securitisation As mentioned earlier, all new products need time to achieve market acceptance. The period when a competing patent first enters the market could provide a window during which an established patent’s revenues are not threatened. If the term of the securitisation is confined to this window, the risk of obsolescence is reduced.
(2) Large cost of replacement technology Licensees often need to make a substantial financial or marketing investment in order to bring products to market using licensed patents. That provides a high barrier to entry for potential new products, limiting the exposure of existing patents to obsolescence. This fact could also discourage competitors from developing competing technologies, further reducing the risk.
(3) Brand recognition Superior technologies often have difficulty overcoming the popularity of existing brands. Therefore, patent income from products with strong brand recognition and loyalty would be more resistant to erosion from new technologies.
(4) Alternative use Patented technology can potentially be applied to a variety of different uses. Development of new uses reduces exposure to a technological advance in one application and expands the patent’s revenue-generating potential.
In each case an analysis of the specific patent will need to be performed to determine how well each of these factors applies. It some cases involving highly technical expertise, independent industry experts may be consulted to assist in the analysis.
Licensee payment risk
Even if the patented technology gains acceptance and remains technically viable, cash flows may not reach investors if licensees default on their payment obligations. A large group of diverse, highly rated licensees mitigates this risk in a patent license fee transaction.
Another potential risk is the expiration of current license agreements during the term of the securitisation. The terms of subsequent agreements can be difficult to predict which will make the level of royalties generated by these agreements difficult as well.
In some licensing agreements, the patent-holder has significant ongoing obligations to the licensee. For example, the licensor could be required to manufacture a necessary component of the final product or to further develop the technology over time, and/or to provide marketing or technical support. Non-compliance with any of these obligations could cause the agreement(s) to be dissolved and interrupt the revenues paid to the securitisation
The licensor also needs be able to properly account for and collect the revenues. If not, revenues generated by the patent will inevitably be missed.
As in a typical securitisation the best way to mitigate this risk is to hire a backup servicer to perform these obligations if the original servicer/licensor should experience difficulties. However, it could be more difficult to find a qualified backup servicer for a patent securitisation, since the technical skills needed might be difficult to replicate. Servicing risk can also be reduced by minimising the licensor’s obligations in their agreements, which would limit the impact of a possible disruption in the event of a bankruptcy.
There are a variety of legal risks that can threaten the revenue stream generated by a patent. These include:
(1) Product Liability Use of the patented technology could result in damage claims for environmental, personal injury, or other forms of negligence that a securitisation could be responsible for.
(2) Patent Challenge or Infringement Challenges to the validity of the patent can be made by third parties causing all or part of it to be overturned. In addition, non-licensed entities could attempt to use the technology without paying royalties.
(3) Expiration By law, patents are valid for only nineteen years after the date of grant.
(4) Bankruptcy Other creditors of the licensor could attempt to claim patent revenues in the event of the licensor bankruptcy.
The extent of the first two of these risks can be assessed
through a review of the history of the patent. If a patent has been in existence
and has been generating revenues for a number of years without these problems
it is less likely to experience them in the future. A long view must be taken
on the risk of product liability however since it could take time for evidence
to accumulate and scientific studies to
be completed assessing damage and causes. Active monitoring by patent compliance specialists can also be done to reduce the risk that unauthorised use of the technology does not occur.
Even if the patent has a long history, these risks can not be eliminated completely. Here too an extensive analysis of potential liability and patent challenges by an independent industry expert might be needed to assess this risk. The use of third party insurer to cover this risk is another alternative.
Another factor that can impact the revenue streams from patent licensing is the expiration of the patents. Both the expected negative impact on the future cash flows and the increased uncertainty around those post-expiration cash flows needs to be evaluated for patents that are scheduled to expire during the life of the transaction. This risk is mitigated to the extent the securitisations hold patents whose remaining lives last well into, or exceed, the term of the transaction.
The risk of seller bankruptcy is a common one for securitisation. As mentioned earlier, it is usually covered through the sale of the assets to a bankruptcy-remote special purpose vehicle (SPV). The use of a SPV is designed to insulate the assets from other creditors of the seller in the event of bankruptcy of the seller. If properly structured, this risk can be greatly reduced, if not eliminated, and allow for the rating of the securitisation to be greater that that of the seller.
Trademark licensing royalties
Trademarks, much like patents, are a right granted by the government to control the use of a logo or brand name. The risks of securitising these rights are also similar to patents. A major difference between the two is that future revenues will be at risk in trademark deals if the image falls out of fashion or popularity as opposed to the technological obsolescence risk of patents.
Three securitisations backed by trademark licensing revenues have been completed. The first was completed in 1999, the second in 2002 and the third in 2003. The 1999 transaction securitised the future revenues generated by the trademark licensing business of the fashion designer Bill Blass. Prior to his death in 2002, Bill Blass was a prominent designer for forty years, with a long history of licensing his name across a wide variety of different product lines. These include men’s and women’s apparel and housewares.
The women’s footwear designer, Candie’s, issued the second transaction. Candie’s has been selling its branded footwear since the early 1980s and has licensed the brand to a variety of product lines including apparel, eyewear, and, perfume.
The most recent trademark licensing transaction, which raised $75 million, was issued by Guess? Inc. (Guess?). Guess? designs, markets and distributes lifestyle apparel, accessories, and consumer products for sale in its own retail outlets and through other retailers. It securitised twelve domestic and two international third-party license agreements for an array of products including watches, eyewear and handbags.
In each of these cases the issuer was able to demonstrate the continued ability of the trademark to generate sufficient future royalties to support debt service. This conclusion was supported by the long history of royalties generated by the brands and the skill of the issuer to successfully manage them going forward.
In addition to traditional forms of asset-backed credit enhancement, all three transactions had features that enabled it to receive either Baa3 (Bill Blass and Candie’s) or Baa2 (Guess?) ratings. These ratings are significantly higher than that of the each issuer’s underlying credit. This was despite significant obligations of the issuer to assist in the generation of future revenues in its role as servicer of the assets.
The first feature was a series of triggers built into each structure related to the financial condition of the servicer/issuer. Essentially these triggers gave investors the right to take control of the assets and place them with a backup servicer, before they lose considerable value and place future debt repayment at risk. In this case a qualified backup servicer with specialised industry knowledge was in place at closing to take over management of the assets, should the original servicer/issuer underperform expectations or fall into financial difficulty. Since the backup servicer had specialised industry knowledge, the risk of a significant drop-off in asset performance due to a servicer/issuer bankruptcy was reduced.
Secondly, the amount of debt financed in relation to the asset’s appraised value, or its loan-to-value (LTV) ratio, was low enough to provide a sufficient cushion for bondholders to be able liquidate the assets in order to repay the bonds if they underperform specified trigger levels. This further protects investors in the case the best efforts of the backup servicer are still unable to improve performance.
Conclusion: IP analysis must be fine-tuned
The securitisation of intellectual property assets is an area that has already included a variety of different industries and asset types. Moody’s incorporates the specific risks posed by these assets into its traditional approach to rating asset-backed securities, providing a consistent way in which to analyse the asset-quality, structural cashflow, and legal risks of the securities. In many cases, these transactions are future flow transactions, which require an additional layer of analysis beyond the traditional assessment of the risks of existing receivables, to include the risks involved in generating receivables in the future.
For the foreseeable future, the analysis of each proposed transaction will be tailored to the particular asset being securitised and will need time to be properly analysed. This article has outlined a number of the major issues that can be identified at this point and indicated how they could affect Moody’s analysis. In doing so, it is hoped that the market will factor in these issues when attempting to structure transactions in what can be a sizable market covering a variety of different industries.